Buy-side liquidity: How technology can enhance Fixed Income liquidity.
Fixed Income markets are based on an underlying assumption that has prevented the development of a market structure that enables liquidity, transparency, and higher volumes.
The old adage that Fixed Income is different because there are so many individual securities, just for one borrower. Therefore, liquidity will always be a challenge.
There are commonly constraints on Fixed Income liquidity with a few notable exceptions, such as the newest or very large Fixed Income securities, but our recent experience has shown us that this is not only due to the number of securities but is also attributable to the capacity of Dealer balance sheets.
In the absence of an unlimited Dealer balance sheet to quote immediate risk transfer pricing on any security in any size, we have unearthed another liquidity dimension and we have made this available to our customers with astonishing results.
It’s called Buy-side liquidity and in some ways, it is profoundly different from traditional Dealer liquidity, but correlates 100% with Equities and Futures.
The thing about Buy-sides is, they own the market. Dealers own very little, especially when netting longs versus shorts, but Dealers do price bonds, take trading risk and can face almost all Buy-sides.
For those still shaking their heads and saying “Fixed Income is different”, we agree! It is absolutely different. But, with a little imagination and clever technology, it is possible to make that difference a virtue for three reasons:
- First, unlike Dealers, Buy-sides don’t have a cost of capital or risk capital charges to contend with when pricing trades. They do have risk, bond and name limits though. They also have very limited counterparty options.
- Second, it is unlikely a Buy-side would ever short a bond, but it may own more than a Dealer ever could or have a larger capacity to accumulate more.
- Third and most importantly, Buy-sides have very different trading objectives from Dealers and herein lies the real potential of Buy-side liquidity.
On any given day the sum of all Buy-side bond orders dwarfs Dealer liquidity. We see this daily in our EMS platform. If that was not a liquidity source worth tapping into, there is also the latent liquidity of existing Buy-side long positions and portfolio capacity. To date, it has not been possible to even glimpse this capacity, never mind activate it, because it all sits in the OMS/PMS.
Technology is the only way to provide the connective tissue to assemble Buy-side actual and latent liquidity into a virtual order book that replicates other asset classes in size and depth.
Back to the world of Equity, Futures and FX, where it is possible to see lit order books with abundant, anonymous liquidity from Buy-sides. All we are doing differently with Fixed Income Buy-side liquidity is coalescing as much latent liquidity from a source that has until now remained largely obscured because it has been isolated in OMSs & PMSs.
Why is Buy-side liquidity obscured and what have we done to expose it?
Let’s be absolutely clear here though, Buy-side priced liquidity and traded volume is still a fraction of the daily traded volume in our system. We managed to energize Buy-side liquidity using our knowledge of other asset classes by cherry picking components that can create the data and workflow to equip a Buy-side Fixed Income Trader in a way that was until recently, inconceivable.
Here is a flavour of what happens:
- The inquiry comes to the Buy-side Trader because a specified interest is flagged e.g. position, watchlist, order or similar to another bond.
- When the Buy-side Trader is alerted they receive an instant pre-trade perspective that covers their trading information (previous RFQs, successful and failed, plus their traded volume) as well as market information (public traded volume, most active Dealers, activity in the name and recent price/spread movement).
- The Buy-side Trader sees present and historical bids, offers, RUNS, live prices and axes.
- The Buy-side Trader can also pre-clear the trade size for internal compliance.
- The Buy-side Trader can understand any trading fees relating to the source Venue so their submitted price or spread can be very finely calibrated to win.
- This can all be automated via our programmatic data API.
Armed with that kind of data firepower it is no surprise Buy-sides want this type of activity to grow dramatically into their prime volume protocol.
Does Buy-side liquidity pose a challenge to traditional Dealer balance sheet?
The Buy-side old guard will always lean heavily on their relationships for Dealer liquidity, so are unlikely to participate or enjoy the benefits of buying at the bid or selling at the offer that this workflow provides.
What may come as a surprise is how effective Buy-side liquidity can be when market volatility drives the Dealer balance sheet to the side-lines. This seems to happen at least once a year and spawns endless media articles about market structure and Dealer dependency.
Regulators have a particular interest in preventing market dysfunction and are increasingly curious about initiatives that could assuage investor exposure in challenging times.
Perhaps less expected is the willingness of Buy-sides to price RFQs from Dealers. The key difference here is the absence of any obligation on the Buy-side to make a price, but in the end, a price is a price and risk transfer is the objective, whoever you trade with.
Dealer to Buy-side volume really has the potential to finally break down the limitations of the current market structure and perceived wisdom. The final hurdle is the ability of OMSs to consume so much granular data and manage execution workflows. Although all users presently trade via the EMS, increasingly the need is for an API version that presents the same EMS data as well as executing via programmatic trading protocols. OMSs have invested heavily in processing more data at higher speeds, but the reality is the trade lifecycle has migrated to the EMS where data aggregation and automation can be seamlessly performed.
The key for us, though, is to have a platform whose integration covers the largest number of trading venues and protocols of any EMS or OMS and has already put into production the comprehensive response mechanism that allows us to scale this effort. It is a seamless order workflow that provides ease of use, speed and safety – all in equal measure.
Before partnering with TSI, we knew the vision, but just lacked the implementation. Now we have the key to the future.”
Spencer Lee, Founding Partner at Agilon Capital, LLC